Topic 10: Investor Behaviour Flashcards
(26 cards)
How do investors improve the performance of their portfolios?
They compare the expected return of a security with its required return from the market security market line
What is the stock’s alpha?
The difference between a stock’s expected return and its required return according to the security’s market line
When the market portfolio is efficient..
All stocks are on the security market line and have an alpha of zero
If the market portfolio is not efficient…
the stocks will not lie on the SML
How can investors improve the performance of their portfolios in terms of alphas?
By buying stocks with positive alphas and selling stocks with negative alphas
- But this will change prices and shift the alphas to zero
What are rational expectations?
All investors correctly interpret and use their own information, as well as info that can be inferred from market prices or the trades of others
Examples of rational expectations?
- In the CAPM, rational investors should hold the market portfolio combined with risk-free investments regardless of the quality of their information or trading skills
- Regardless of how much information an investor has access to, a rational investor can guarantee himself an alpha of zero by holding the market portfolio
_ This is because the average portfolio of all investors is the market portfolio, the average alpha of all investors is zero
_ If no investor earns a negative alpha, then no investor can earn a positive alpha, and the market portfolio must be efficient
Market portfolios can be inefficient only if a significant number of investors either:
- Misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha
- Care about aspects of their portfolios other than expected return and volatility, and so are willing to hold inefficient portfolios of securities
How can individual investors fail to diversify their portfolios adequately?
- Familiarity Bias: Investors favour investments in companies they are familiar with
- Relative Wealth Concerns: Investors care more about the performance of their portfolios relative to their peers
- Excessive Trading: A tremendous amount of trading occurs each day. While according to the CAPM, investors should hold risk-free assets in combination with the market portfolio of all risky securities
- Overconfidence bias: investors believe they can pick winners and losers when, in fact, they cannot; this leads them to trade too much
- Sensation seeking: An individual’s desire for novel and intense risk-taking experiences
If individuals depart from the CAPM in random ways..
- Then these departures will tend to cancel out
- Individuals will hold the market portfolio in aggregate, and there will be no effect on market price or returns
Examples of Systematic Trading Biases
- Disposition Effect
- Investors Attention
- mood
- experience
- herd behaviour
- Informational Cascade effects
What is the Disposition effect?
Investors hold on to stocks that have lost their value and sell stocks that have risen in value since the time of purchase
What is Investor attention?
Individuals are more likely to buy stocks that have recently been in the news, engaged in advertising, experienced exceptionally high trading volume, or have had extreme returns
Mood in Systematic trading bias?
Sunshine generally has a positive effect on mood, and studies have found that stock returns tend to be higher when it is a sunny day at the location of the stock exchange
Experience in Systematic Trading Bias
Investors put too much weight on their own experience rather than considering all the historical evidence. People who lived during a time of high stock returns are more likely to invest in stocks than people who experienced times when stocks performed poorly
Herd Behaviour
Investors make similar trading errors because they are actively trying to follow each other’s behaviour
Informational Cascade effects
Traders ignore their own information hoping to profit from the information of others
What are the implications of Behavioural Biases?
- If individual investors are engaging in strategies that earn negative alphas, it may be possible for more sophisticated investors to take advantage of this behaviour and earn positive alphas
- The CAPM wisdom that investors should ‘hold the market’ is the best advice for most people
The performance of fund managers
- The median mutual fund actually destroys value
- Most fund managers appear to trade so much that their trading costs exceed the profits from any trading opportunities they may find
- Numerous studies report that the actual returns to investors of the average mutual fund have a negative alpha
- Superior past performance is nota good predictor of a fun’s future ability to outperform the market
What is the Market Capitalisation Strategy?
Buy small market capitalisation stocks and sell large market capitalisation stocks
What is the Book-to-Market Strategy?
Buy high book-to-market stocks and sell low book-to-market stocks
What is the Momentum Strategy?
Buy stocks that have had high past returns and (short) sell stocks that have had low past returns
What are implications of Positive-Alpha Trading Strategies
- The only way positive-alpha strategies can persist in a market is if some barrier to entry restricts competition
- However, the existence of these trading strategies has been widely known for more than 15 years
What is a proxy error?
The true market portfolio may be efficient, but the proxy we have used for it may be inaccurate
